Don’t Be Seduced By Real Estate Investment’s Version of Hide the Pea

Back in the 80’s when tax shelter Nirvana became law (15 year depreciation schedules), I had folks linin’ up like my office was 31 Flavors, and double scoop cones were a nickel apiece. It was crazy. All of a sudden, real estate was reaching folks who’d been on the fence their entire adult lives.

I’d ask them, “So, you wouldn’t invest for capital growth or cash flow, but if you can save a few dollars in taxes you’re in the front of the line?”

Some would actually be a little offended. Really? I’d then give them an instant replay of the decade they’d just purposefully missed. Did this first around 1983. One client in particular was both astounded and nonplussed when apprised of what he’d missed from 1975-1979. And remember, this was in San Diego where, back in the day we thought 5% appreciation meant we’d experienced a down year. In fact, if he’d invested just $40,000 in early ’75, he’d of easily had close to $250,000 by ’80. No joke. Happened almost routinely. We were to learn much later that that market run-up was merely an audition for the next two, especially the mother of all up markets recently experienced.

Don’t play hide the pea — the game’s rigged for you to lose when it counts.

Since 1976 when I transitioned from the traditional home sales market to investments, there’ve been several times when relatively artificial ‘attractions’ have been created to encourage investment. With one stellar exception, ERTA in 1982 or ’83, they’ve usually been cleverly disguised mirages.

Bottom line? If you’re buyin’ poorly located real estate with questionable construction quality to boot, with semi-shady built-in rental ‘guarantees’, I have some advice for ya.

Run! As fast as you can for as long as you can. If you wouldn’t buy the property on its own merits, based on OldSchool fundamentals, why on earth would ya buy it cuz it has a bit more tax shelter? Or a guaranteed rent setup? My question has always been, if the seller wants to guarantee something till it rents out on its own? Fair enough, that makes sense, and I’ll go with it most times. In fact, I do that now sometimes.

That’s the exception though. Most times these so-called rent guarantees, usually for 2-3 years, have to be put in force cuz they simply can’t rent them in the real local market for the guaranteed amount, or to tenants who wouldn’t scare ya. It’s important to be able to discern the difference between a short term guarantee created to bridge a time gap between being vacant and finding a new acceptable, qualified tenant, and guaranteeing rent cuz you know the dang thing can’t be rented unless you give away the store.

If the location is top drawer quality, and the construction the same, that’s a great start. Then, if you discover that the local rental market is strong and will deliver rents supporting the purchase price, all the better. And if those rents will be paid by a high quality tenant, then you’ve got your fundamental ducks in a row. If the enhanced tax shelter comes on top of all those factors, go for it. If not, let me tell ya what’s in your future.

After a couple three years, the guarantee will have run its course. Since you chose to overlook the fact that the local rental market sucked like a turbo charged Dyson, you’re about to pay the piper. Poor quality tenants with bad credit at rents nowhere near what had been your guarantee. Also, you’ve learned the hard way how mediocre the quality of material and construction was. Too late, big guy.

Hey, how’s that extra tax shelter workin’ out for ya now?

If you wouldn’t buy the property but for the extra tax savings — don’t buy it. Learn the easy way. Tax shelter, long gone, is not gonna put food on the table and a roof over your head in retirement. ‘Course, there’s always the problem, down the road, of finding the next sucker to buy it when you want/need out.

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5 Comments

That’s a great analogy, Jeff. It’s a bit like using adjustable-rate mortgage, you go for the short-term gain but get hit hard in the long-term. It’s just important for people to recognize the big picture before going into any “investment”.

Also what did you mean when you wrote ” My question has always been, if the seller wants to guarantee something till it rents out on its own? Fair enough, that makes sense, and I’ll go with it most times. In fact, I do that now sometimes.”. I got the first part part of that paragraph though 🙂

ERTA was the Economic Recovery Tax Act of 1981. One of it’s major incentives to private investment was ACRS, the replacement for the traditional formula for depreciation. ACRS stood for Accelerated Cost Recovery System. A fancy way of sayin’, “You can buy real estate and double, give or take, what you’ve normally been able to take for annual depreciation.” And remember, ‘loss’ depreciation provides investors is on paper only. There’s no actual money lost.

It was especially effective for highly taxed, large wage earners. An example from my files was a high income client who was paying stoopid high fed/state income taxes. When he saw my analysis of his situation showing how he could eliminate 80-90% of those taxes by investing heavily into real estate, using aggressive leverage, he pounced. 18 months later his tax returns showed a decrease in total taxes paid of just under 90%. His capital growth was more impressive than that — by far.

When someone comes to you with a ‘great investment’ that offers ‘over the top’ tax shelter along with ‘no risk, 1-3 year rent guarantees’, step back and ask yourself some questions.

1. How putrid is the location that in order to sell the income properties the seller(s) must preemptively offer solutions to the fact the local market tenant demand is either shamefully low, or nonexistent?

2. Why would they inflict on themselves the expense of 12-36 months of guaranteed rents at rates demonstrably ABOVE what can be easily shown through ‘boots on the ground’ research?

3. Why do you think that rental market will suddenly morph into dynamically favorable when the guarantee ends?

4. Are you counting heavily on Section 8 to save your bacon? If so, good luck with that.

5. If congress has seen fit to grant that locale a special tax shelter plan to entice investors to bring their capital into the area, why weren’t the investors buying there before? Was it cuz buyin’ there reminded them of the joke about makin’ a small fortune?

How do ya make a small fortune buyin’ income property in X-City’s real estate market?

Oh, that’s simple. Just start with a large fortune. Badda boom!

6. Would you buy this property without the bonus tax shelter and/or rental guarantees?

On the other hand . . .

In countless transactions over the years as seller/broker/buyer/group leader, I’ve gone along with various forms of rent guarantees. The difference in those scenarios however, was that my own, and in many cases, their own boots on the ground research revealed a ‘normal’ if not strong rental market.

Sometimes a short term guarantee/credit is to compensate for closing in the winter, when vacancies in regions with ‘real’ winters are difficult to fill. Or, it’s a ‘new’ area just establishing itself. The rent credit or guarantee is for a known/accepted reason — no big deal. Then there’s the seller who realizes he’s not kept up with the rent levels in the area. They will often agree to ‘make up the difference’ with a 3-6 month credit to the buyer. This is an intelligent concession for the seller, as the credit is typically measured in three figures, or very low four figures in terms of dollars, while he is able to then sell for at or close to market price ‘as if’ his rents are already where they should’ve been.

The crucially pivotal difference between a market negotiated rent credit/guarantee and an artificial, disguised long term rent guarantee is the difference between a great steak, and an undercooked chicken that gives you food poisoning. Wouldn’t you have passed on the bad chicken if you knew it’d make you sick? We all would.